Why the Banks' Party May Be Over

Rising interest rates and regulatory reform could be a drag on earnings.

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The Federal Reserve says banks must take steps to prevent possible losses when interest rates are hiked.

The Fed didn't say when or how sharply it might boost short-term rates from the current record low. But regulators advised banks to calculate the effect of "instantaneous and significant changes" in interest rates and "substantial changes" over time, including possible shifts of as much as four percentage points.

"In the current environment of historically low short-term interest rates, it is important for institutions to have robust processes for measuring and, where necessary, mitigating their exposure to potential increases in interest rates," the Fed says.

Higher rates are almost certainly in the offing. Charles Plosser, the president of the Philadelphia Federal Reserve Bank who has developed a reputation as an inflation hawk, last month said it may be necessary to boost rates before unemployment falls to "acceptable levels."

"Looking ahead, I see an economy that will be growing over the next two years, which means real interest rates will be rising," he said in remarks prepared for delivery at the University of Rochester in New York.

Economists surveyed by Bloomberg News expect the Fed to increase the benchmark federal funds rate in the third quarter of 2010. Last month, the Federal Open Markets Committee voted unanimously to keep rates "exceptionally low" for an "extended period." The current rate is close to zero.

But on Friday, a research report issued by Citigroup (C) cast a decidedly downbeat view on the sector. Analyst Keith Horowitz expects regulatory reform to take a bite out of revenues across the board, and he adjusted his EPS estimates as a result. He now looks for Bank of America (BAC) to lose $0.66 a share in the fourth quarter compared with the consensus estimate of a loss of $0.51. He cut earnings for Goldman Sachs by $0.25 to $5.25 a share compared with the consensus estimate of $5.34 and he lowered the earnings estimate for Morgan Stanley (MS) by $0.30 to $0.36 compared with the consensus estimate of $0.49 a share. The analyst cut JP Morgan Chase (JPM) earnings per share by $0.15 to $0.55 compared with the consensus earnings estimate of $0.63 a share.

Meredith Whitney, head of Meredith Whitney Advisory Group and known for her downbeat view of banks during the financial crunch, earlier this week lowered her earnings estimates for Goldman Sachs and Morgan Stanley. In December, she cut her estimate for JP Morgan Chase.

Analysts say smaller banks also may be squeezed by rising short-term rates, especially those relying heavily on collateralized mortgages. Last year, 140 US banks failed, the greatest number since 1992.

Rising rates and more stringent regulation could whipsaw bank earnings.

Peter Atwater, president and CEO of Financial Insyghts and a Minyanville professor, says the current wave of populist reform may create a "Robin Hood economy" by redefining stealing from the "rich."

"And there were other minor battles that played out over the past year in Washington, with Congress and the Federal Reserve approving 'consumer friendly' regulations covering everything from the interest rates on credit cards to the overdraft fees on checking accounts -- populist reforms at the expense of future 'faceless' too-big-to-fail bank earnings," Atwater says.

Ending universal default: Card issuers will no longer be allowed to boost interest rates based on a customer's behavior on unrelated accounts such as skipping a payment on the utility bill or receiving a lower credit score.

Later payment deadlines: Card issuers will be required to mail billing statements 25 calendar days prior to the due date, ending the current minimum of 14 days.

No sudden rate increases: "Any time, any reason re-pricing" will be prohibited, ending arbitrary rate increases.

Set limits on credit: Consumers will have the option to have a fixed credit limit that can't be exceeded, preventing card issuers from charging hefty fees for exceeding the limit.

Allocation of payments: Card issuers will be required to fairly allocate payments on balances with different interest rates, ending the practice of crediting low-interest balances first and running up the charges or balances with higher rates.

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